Evaluating the Big Five Fundamental Ratios

In stock investing, conducting fundamental analysis involves examining a company’s financial records to evaluate its financial health and future prospects, aiding in investment decisions. However, reading lengthy annual reports filled with financial jargon can be daunting and time-consuming. Fortunately, financial ratios simplify this process, providing a quick and efficient way for investors to assess key aspects of a company’s performance without extensive calculations. Let us find out what the ’big five’ fundamental ratios are. 

Defining Fundamental Analysis

Fundamental analysis is a method used to evaluate the intrinsic value of a stock by analysing a company’s financial statements, management, industry position, and economic conditions. 

• This approach focuses on assessing the underlying factors that can influence a company’s future performance and stock price. 
• Fundamental analysts examine various aspects of a company, including its revenue, earnings, assets, liabilities, growth potential, competitive advantages, and market trends, to determine whether a stock is undervalued, overvalued, or fairly priced. 

Defining a Fundamental Ratio

A fundamental ratio is a quantitative measure derived from a company’s financial statements, used to assess its financial performance, health, and valuation. 

• These ratios provide insights into various aspects of a company’s operations, such as profitability, liquidity, efficiency, and solvency. 
• By analysing fundamental ratios, investors can make informed decisions about investing in a particular company, comparing its performance to industry standards and benchmarks.
• Examples of fundamental ratios include price to earnings ratio (P/E), debt to equity ratio, return on equity (RoE), and current ratio.

Significance of Fundamental Ratios

Fundamental ratios play a crucial role in investment analysis by providing valuable insights into a company’s financial health and performance. 

• These ratios serve as key metrics for investors to assess various aspects of a company’s operations, including profitability, liquidity, efficiency, and solvency. 
• By analysing fundamental ratios, investors can make informed decisions about investing in a particular company, identifying potential risks and opportunities, and comparing its financial performance to industry benchmarks. 
• They help investors evaluate the valuation of a stock, determining whether it is undervalued, overvalued, or fairly priced relative to its intrinsic value. 
• Overall, fundamental ratios serve as essential tools for fundamental analysis, guiding investors in their decision-making process and contributing to long term investment success.

Big Five Fundamental Ratios

Price to Earnings (P/E) Ratio

• As the name suggests, a P/E ratio is the ratio of the current share price to the earnings of the company per share. This ratio can tell one if the company is undervalued or overvalued in the market.
• The price to earnings ratio is one of the most widely used ratios by investors throughout the world. 

P/E ratio is calculated by: P/E ratio = (Market Price per share / Earnings per share)

• Let’s say that a company has an overall earning of ₹100. Also, it has 10 shares trading in the market. 
• Therefore, its earnings per share is ₹10. 
• Further, let’s say that the shares of the company are trading at ₹100 per share.
• Hence, we have: P/E ratio = 100/10 = 10

In the simplest terms, this means that one is paying ₹10 for getting Re.1 from the company’s earnings. Hence: 

• It is easy to deduce that if a company has a higher P/E ratio, it is that much valued (or sometimes overvalued!).
• A company with a lower P/E ratio is considered undervalued compared to another company in the same sector with a higher P/E ratio. 

It’s important to note that the average P/E ratio varies across industries. For instance, oil and refinery companies typically have a P/E ratio of around 10-12, while FMCG and personal care companies may have a P/E ratio of 50-55. Therefore, comparing the P/E ratio of companies from different industries isn’t meaningful. However, within the same industry, comparing the P/E ratios of different companies can help identify undervalued options.

Return on Equity (RoE) Ratio

• The RoE ratio is a measure of the rate of return on the stock of a company. In other words, it tells investors how good the company is at generating returns on stock investments. 

It can be calculated as: ROE = (Net income / average stockholder equity)

• A higher ROE means that the company generates a higher profit from the money that the shareholders have invested. 
• Always invest in companies with an average RoE for the last 3 years greater than 15%.

Let’s say that one contributed Re.1 in equity of XYZ company and the total equity of the company is ₹10. Using this equity if the company generates an income of ₹2, then the RoE is 20%. Imagine another company with the same total equity but generating an income of ₹4. Its RoE ratio will be 40%. The company that generates better RoE is considered better.

However, one should not look at RoE as a standalone factor. 

While RoE is a valuable metric for assessing a company’s profitability relative to its equity, it doesn’t provide a complete picture of the company’s financial health. Other factors such as debt levels, industry dynamics, economic conditions, and management quality also play crucial roles in determining a company’s overall performance and long term sustainability. For example:

• Like the P/E ratios, the RoE ratios can vary according to sectors and industries. Hence, it is important to understand the industry average too.
• A company can also have a high RoE ratio because it has taken a lot of debt and its equity investment is low. Hence, one must look at the equity structure of the company along with its complete financials to make the decision.

Dividend Yield

• Dividends are the profits that the company shares with its shareholders as decided by the board of directors. 

Dividend yield can be calculated as: Dividend yield = (Dividend per share / price per share)

How much dividend yield is good?  

• It depends on the investor’s preference. 
• A growing company may prioritise reinvesting profits into expansion rather than offering high dividends, potentially leading to significant capital appreciation. 
• Conversely, established large companies often provide substantial dividends but may exhibit slower growth rates. 
• Ultimately, investors must decide whether they prefer high-yield stocks or those with growth potential. 
• As a rule of thumb, consistent and increasing dividend yields over the past few years often indicate healthy financial performance by the company.

Debt to Equity (D/E) Ratio

• This ratio gives one an overview of the debts and equity of the respective company. 
• It is calculated by dividing the company’s total liabilities (debts) by its total shareholder equity. 
• It can give one an indication of how much the company is running on loans versus owned funds.
• There is no ideal D/E ratio as it can vary with industries and sectors. Usually, if a company has a lot of debt, then it is assumed that the company will find it difficult to pay it back. Also, since debt attracts interest, it will directly impact the company’s profit and loss statement and negatively impact its net income leading to a drop in the cash flow.
• The D/E ratio can help one determine the magnitude of debt that the company has. A high D/E ratio means higher debt and vice-versa.
• Although having debt is not always a bad thing, debt also means that if the company repays the interest on time, it can help in the growth of the company.

Current Ratio

• It tells one about the ability of a company to pay its short term liabilities with short term assets.

The current ratio can be calculated as: Current ratio = (Current assets / current liabilities)

• Investing in companies with a current ratio greater than 1 should be preferred. This means that the current assets should be greater than the current liabilities of a company.
• A lower current ratio indicates that the company doesn’t have enough liquid assets to cover its short term liabilities.
• A higher current ratio means the company will not be affected by working capital challenges and a lower ratio (i.e. below 1) could be a problem. But sometimes a really high current ratio could also indicate that a company is not using its current assets efficiently or is unable to secure financing well.

Conclusion

While conducting a thorough fundamental analysis of a company is essential, these ratios offer a quick overview of its financial health. It’s crucial to recognise that these ratios are dynamic and should be regularly reviewed to ensure an accurate understanding of the company’s current situation. By analysing these fundamental ratios, investors can make more informed decisions about their investments and navigate the stock market with greater confidence.

Frequently Asked Questions (FAQs)